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Chavez's Health and Implications for Chinese Investment

For those of you keeping up with the much-discussed energy deal between China and Russia, you know the many reasons, both geographic and political, why it's unlikely to pan out. The geopolitically savvy folks over at STRATFOR told us about it a couple of weeks ago, and have moved their forecasting on to an existing energy relationship, between China and Venezuela—now potentially uncertain due to Hugo Chavez's precarious position in a Cuban hospital.

Whether Chavez gets better or not, a political transition is down the line somewhere, and China could lose its current preferential treatment as primary investor in Venezuelan oil. This is the kind of thing we have to know about as investors. Yes, we all know that Chavez is ill. But what, if anything, does that mean for the South American energy sector? What about the future of oil, China, the U.S., and so on? This is the kind of forward-looking analysis you get from a news publication like STRATFOR. It doesn't get any better than these guys.

Enjoy this complimentary piece from them. If you're interested in more, watch their video on the << Venezuelan oil industry here>>, and then take advantage of their special discount for OTB readers. I read them every day, and highly recommend you check out their subscription offer.

John Mauldin, Editor Outside the Box

Summary

The absence of Venezuelan President Hugo Chavez due to health reasons has caused uncertainty about Venezuela’s future, and this is cause for concern in China. China has made significant financial investments in and commitments to Venezuela, from which Venezuela has benefited greatly. China risks losing billions of dollars if Venezuela destabilizes, and in the long term, it fears losing the standing preferential relationship with Caracas if the government changes and Venezuela begins to look elsewhere for technical expertise to accompany investment.

Analysis

Venezuelan President Hugo Chavez appeared on Venezuelan television June 29 in a recording that was reportedly made the morning of June 28. It is unclear from the video exactly how healthy the South American leader is after he was hospitalized in Cuba on June 10, undergoing abdominal surgery apparently related to prostate cancer. Though he reportedly intends to return to Caracas by July 5 for the country’s independence day and bicentennial celebration, it is not yet clear that he will be well enough to do so. With Chavez having been in a Cuban hospital for nearly three weeks, Venezuela has been rife with rumors about his sickness, and a power struggle among his inner circle has been under way.

There are many players with a stake in the Venezuelan regime, but one of the most important in the past several years has been China, which could be affected greatly by a transition in Venezuela’s government. China does not stand to lose much in the short term and hopes to continue investing in Venezuela, but a transition away from Chavez and Caracas’ need for technical expertise to accompany investment could threaten China’s preferential standing with Venezuela.

Chinese Interests in Venezuela

China has not commented officially on Chavez’s illness, but China has become increasingly invested in Venezuela and has built a unique relationship with the Venezuelan government. Although the exact numbers have been difficult to confirm, since 2005, China has made hard asset investments and loans as well as commitments for further loan and investments to Venezuela worth about $49.5 billion. Some of the loans have reportedly been paid back in oil, and about $10 billion worth of loans will reportedly be delivered in yuan, which China can print at will and is only accepted as currency by the Chinese government and firms. The terms on the financing vary, but China has been careful to ensure that it has taken a strong role in how the money is spent, with joint decision-making on the projects and a commitment to hiring Chinese firms written into the agreements. Of the total amount that has been invested and discussed, we estimate conservatively that China could be exposed to losses of around $14 billion if Venezuela reneged on its commitments.

China’s interest in Venezuela is multifaceted. In the first place, Venezuela has one of the largest energy reserves in the world, with proven oil reserves of 211 billion barrels and 179 trillion cubic feet of proven natural gas reserves. Much of this oil is so thick it requires special processing before it can be shipped to a refinery. By establishing a relationship with Venezuela, China not only has a chance to learn some of the processing techniques for heavy, sour crude oil, which is an increasing portion of the global oil mix, but it also is able to actually invest in oil production that supplies its own consumption market. Both of these interests are being addressed in a pending deal to build a refinery with a capacity of 400,000 barrels per day in China’s Guangdong province.

Second, China has a global outward investment strategy that has targeted Venezuela, among others, for its natural resources and opportunities for Chinese business. This strategy allows China to invest its massive cash surpluses in hard assets worldwide and helps it handle domestic money growth. It also expands markets for Chinese exporters and state infrastructure and industry. China has long invested in several extremely risky countries and governments at variance with the United States or the West, or otherwise viewed as at high risk of instability, including North Korea, Myanmar, Iran, Sudan, Angola and Venezuela. Having arrived late in the global race for resources and markets, China has seized opportunities shunned by the West, and with its large cash reserves and willingness to offer financing without political requirements, it has attracted interest from these regimes.

Investment in Unstable Countries

China generally believes it can secure its investments by cultivating relations across these countries’ regimes and political elite, though it is well aware that losses could result when it chooses to invest in unstable countries. Outside of Venezuela, China has a number of investments worth hundreds of billions of dollars in unstable countries. STRATFOR sources suggest that China may have more than $30 billion at risk in Libya, where it has recently begun negotiating with the rebels to try to ensure that interests established under the regime of leader Moammar Gadhafi will be protected under any potential Libyan government ruled by the rebels. Chavez’s illness and the instability in Libya (as well as the broader Middle East and Africa) reveal a certain degree of strategic weakness inherent in investing in potentially volatile emerging markets, especially where China’s main advantage is the regime’s estrangement from China’s competitors in the West. The potential loss of tens of billions of dollars worth of investment into these economies has prompted a reconsideration of such risks, but STRATFOR sources suggest that Chinese bank regulators’ latest attempts to pull back on foreign investments and loans have been rebuffed by the Chinese national banks.

For Venezuela, the relationship with China has been important for both financial and political reasons. Since the 2002 coup attempt against Chavez — during which the United States was quick to acknowledge the military leaders that briefly took power — Venezuela has been working to isolate itself from the United States by seeking alternative allies and diversifying its oil export markets. As the most aggressive global lender, particularly in the wake of the financial crisis when lending was nearly nonexistent, and a huge consumer of oil, China has become a natural partner for Venezuela. Presiding over an increasingly unstable economy, Chavez has needed to increase borrowing to cover expenditures and debts on a number of fronts. From a severe national housing shortage to a deteriorating electricity system and an oil sector suffering from severe mismanagement and underinvestment, Chavez has needed the Chinese as a political backer, but most important, as a financi al backer. This need has meant that China has enjoyed a great deal of leverage over Venezuela and made it easy for China to get the terms it wanted on the loans and investments it made.

Implications of Chavez’s Illness

The Venezuelan government is highly personalized, and a great deal in Venezuelan politics relies on the personal preferences of Chavez. There are no other leaders who are positioned to take control in a scenario where Chavez is incapacitated or a change in government becomes a necessity. China worries that if something were to happen to Chavez, their preferential treatment and access to investments and financing could dissipate. This concern to extend the relationship beyond the confines of a personal relationship with Chavez can be seen in the successful push that got the terms of Chinese loans written into Venezuelan law. The Chinese could still make deals with a new Venezuelan government, but it would require forming relationships with a whole new ruling elite.

In the short term, the risk posed by Chavez’s current illness is that there could be a destabilization of the government if he is not able to return to power in the near future. This could directly threaten China’s in-country assets. However, unless the country dissolves into civil war and outright destroys Chinese direct investments, it is unlikely that a successor government would walk away from its debts to the world’s biggest lender. And, for China, this is a relatively small amount of money, as its annual external investment totaled around $59 billion in 2010 alone.

The longer-term reality is that China will lose its preferential access to Venezuelan resources. Even if Chavez’s current illness does not bring about a change in government, a transition is in the cards at some point, and a change in the Venezuelan government may shift the incentives that make the current partnership with China so important. It is Chavez’s policy of isolation from the United States combined with China’s “no strings attached” lending policy that makes China a perfect partner for the moment.

However, there are opportunity costs accruing to Venezuela as a result of its commitments to China. Venezuela’s oil industry is suffering from a profound lack of technical expertise to accompany investments, and the Chinese simply do not have the technical ability to help revive dwindling production.

The pressing need for Venezuela to resuscitate its oil industry with foreign expertise will eventually necessitate a reconsideration of its isolationist policies — and a leadership change will make this more of a political possibility than it currently is under the Chavez administration, as it will require a more conciliatory posture toward the United States. For China, this will mean higher competition for access to Venezuelan energy resources, and although no one can compete with China’s quantity of cash, it does not have the expertise Venezuela needs.